U.S. Tax Residency & The Tax Treaty Tie-Breaker

U.S. individual income taxation is based on both residency and citizenship. Figuring out whether you are a U.S. resident for tax purposes can be complicated. A sound understanding of the tax rules is key.

While non-residents are only taxed on income sourced to the U.S., U.S. citizens and residents are subject to U.S. income tax on worldwide income.  In addition, residency for state, estate and gift taxation may differ, with some rules driven by factors such as domicile, or days of presence. Where should your analysis begin?

Well, the U.S. has four key “bright line” tests for determining residency:

1. United States Citizenship;
2. Lawful Permanent Residence;
3. Substantial Presence; and
4. First-Year Election.

 United States Citizenship

U.S. citizens generally include all persons born in the U.S. It may also include individuals born to a U.S. citizen. If you’re born abroad to parents where either one or both are American citizens, you may be considered a U.S. citizen as well.

 Lawful Permanent Residence

Lawful permanent residence applies if you hold a green card at any time during a calendar year. The status is retained unless revoked, or otherwise administratively or judicially determined to have been abandoned.

 Substantial Presence

This test if met if an individual is physically present in the U.S. for at least:

1. 31 days in the current calendar year; and
2. 183 days over a three-year period that includes the current year and the preceding two year computed as follows:
   1. All the days of the current year;
   2. 1/3^rd of the days in the preceding year; and
   3. 1/6^th of the days in the second preceding year.

When counting days of presence in the U.S., an individual is considered to be present in the U.S. on any day they are physically there.

 Exceptions to Days of Presence in the U.S.

There are some instances in which your days of presence in the U.S. may not count towards meeting the substantial presence test. Factors that may result in you excluding days in the U.S. towards substantial presence include:

1. regularly commuting to work in the U.S. from Canada or Mexico;
2. being in transit between two places outside the U.S. and present in the U.S. for fewer than 24 hours;
3. a medical condition developed in the U.S. that prohibits you from leaving the U.S.; and
4. being considered an exempt individual under certain U.S. visa types that may include students, teachers, trainees and foreign government employees.

 The Closer Connection Exception

Now, even if you’re considered a U.S. resident as a result of the substantial presence test, it may be possible to be treated as a non-resident for U.S. tax purposes under the “Closer Connection Exception.”  However, for this exception to apply, an individual who otherwise meets the substantial presence test must also:

1. be physically present in the U.S for fewer than 183 days in the current year;
2. have maintained a tax home in a foreign country during the current year; and
3. have a closer connection to a foreign country that is not the U.S.

Both the terms “tax home” and “closer connection” have specific meanings under the U.S. tax code.  “Tax home” refers to an individual’s regular or principal place of employment or business. “Close connection” refers to an individual’s significant social ties and assets including:

1. family and belongings;
2. permanent home; and
3. country of residence designated on tax forms.

A Form 8840, Closer Connection Exception Statement, must be filed to claim this exception. Filed an income tax return for the year? Include the exception statement with it. If no return is filed, then the Form may be filed separately.

 Tax Treaty Tie-Breaker Rules

Now, it is possible to be considered a resident of both the U.S. and Canada. But, using the tie-breaker rules, under the U.S. Canada Tax Treaty, it may be possible to resolve some issues with potential double taxation. It may even be possible to move from a U.S. resident status, to being considered a non-resident. If this applies, you would file a Form 1040NR, U.S. Nonresident Alien Income Tax Return, and a Form 8833, Treaty-Based Return Position Disclosure Under Section 6614 or 7701(b).

 First-Year Election

To utilize certain tax benefits, a non-resident alien may wish to be treated as a U.S. resident alien for the entire tax year. This would permit the individual to claim certain deductions and credits, as well as preferential tax rates. However, since electing to be treated as a resident alien in a tax year also means being taxed on worldwide income, the pros and cons of making such an election should be carefully considered.  This may make sense if you move into the U.S. from Canada. Canadian tax rates are generally higher, and you may be able to satisfy much of your tax obligations with foreign tax credits and or the foreign earned income exclusion.

Got U.S. tax and Canadian tax compliance issues? Contact Cross-Border Financial Professional Corporation – When Perspectives Matter!

 Karlene J. Mulraine, EA, CPA, CA, CPA (NH) is the President of Cross-Border Financial Professional Corporation. Follow us on Linkedin and Twitter, or hang out on Facebook.

The views expressed in this article are those of the author and should not be relied on to make decisions. Consider discussing your specific circumstances with an appropriate specialist.